Mind the Gap: The Unforeseen Consequences of Smart Beta

A new paper by Sean Markowicz,a strategist at Schroders,looks into the possibility that fund flows into the assets generically called smart beta are having detrimental consequences for the financial system. It also sheds some light on investors’ bad timing regarding ETFs.

The assets at issue are, according to Markowicz, “alternative approaches to passive index investing,” especially those with “a sector bias or a methodology driven by some fixed rule other than simple market capitalization.”

The numbers show that a move toward such approaches is very much upon us. Alternative equity index ETFs are now “even more popular than traditional … ETFs that track established market benchmarks such as the S&P 500 index.”

But the trend thus far has not rewarded investor interest. The alternative index ETFs have returned 9.8% per annum over the last five years, less than the 10.5% average per annum returned by the traditional broad market ETFs.

Yet Markowicz’ concern isn’t as much with performance as it is with unexpected side effects of the growth of such alternatives. Markowicz focuses on claims that excessive fund flows focusing on specific market segments have put disproportionate pressure on underlying stock prices and that the way investors employ alternative ETFs may worsen market shocks.

Market Cap and Liquidity

As to the impact on prices and volatility, Markowicz observes that “many ETFs, ironically, still weigh their constituents based on market capitalization.” Thirty-two of the top 50 alternative index ETFs (ranked by AUM) weigh their portfolio holdings exclusively in that traditionalist manner rather than through any strategic surrogate.

Ironic though it may sound, this is not surprising. ETFs of any variety offer their investors intraday liquidity. It is a key selling point. To do this, they must have liquid constituents. And that need pushes ETFs toward weighting on market cap, particularly in the larger caps, which are the deeper liquidity pools.

But the concern is that this feature of ETFs, coupled with the growth of the ETFs with strategic mandates, could produce extra downward pressure on the prices of the large-cap stock in the event of a reversal: the chaos of a large crowd trying to exit from the same room. For example, on Dec. 24, 2018, the US Treasury Secretary convened large banks’ executives to talk about liquidity and President Trump wondered aloud whether he had the authority to fire the head of the Federal Reserve.

This news spooked the markets (which approve of an individual Fed and dislike anything that smacks of a banking-related emergency summit). Investors redeemed $3.8 billion out of their alternative index ETFs, presumably not just so that they could fill the others’ stockings for the next morning. Markowicz calls this level of redemption a “1.5 standard deviation shock to average daily flows.”

Did the smart beta redemptions create a feedback loop and worsen the S&P decline? It is not easy to nail that down, but Markowicz believes that there was “some [extra] downward pressure on stock prices on the day.”

A Conclusion and some Numbers

From such considerations Markowicz concludes that the smart-beta skeptics have a point. The spread of this index-tracking but not-so-passive investors may, he says, be “storing up trouble.”

Further, Schroders research indicates that, “in aggregate, investors are poor at timing their ETF investments and would do better by adopting a buy-and-hold strategy.”

The report offers some deal on the “return gap” here. The return gap is the difference between an ETF’s money-weighted rate of return and the time-weighted rate of return. While the MWRR measures performance adjusting for inflows and outflows, the TWRR measures only the compound rate of return of a dollar invested in the fund. TWRR abstracts from the timing element. To the extent that MWRR is below TWRR, bad timing has hurt performance.

For example: for the SPDR S&P 500 ETF, the one-year return gap is 1.73%. In that case, the timing of flow has had a positive effect. But for that same ETF, the three-year return gap is sharply negative: -6.7%. The five-year gap shows a rebound but is still well in the red, -4%.

Looking at a more strategic, and if you will a “smarter” fund, the Vanguard Real Estate ETF: Schroders’ numbers show that all three return gaps are negative. For one year, -0.35%. For three years, -1.0%. For five years, the gap is abysmal, -8.1%.